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Eurozone: Will the bail-out keep another “Great Depression” away?

If you think eurozone is now out of the danger zone after a stronger bailout fund, you may be in for a big disappointment. The zone will have to pay the price for taking along its continental baggage; the looming Greek default. Financial markets are already anticipating a likely Greek default and demanding more far-reaching measures to prevent the crisis that began in Athens from spreading far beyond Europe and its banks. The Greek government will run out of money to pay salaries and pensions in October unless it receives the next 8 billion euro installment of emergency loans. It pushed an unpopular new property tax through parliament this week despite public anger. Anti-austerity protesters blocked the entrances to several ministries before the start of the talks.

The savior is Germany this time which demonstrated its commitment to the euro and to protecting the currency. The Bundestag (lower house) overwhelmingly approved new powers for the 440-billion-euro EFSF fund to make precautionary loans, help recapitalize banks and buy distressed countries’ bonds in the secondary market. Despite a rebellion by 15 backbench Euroskeptics, Merkel won 315 votes from her own center-right coalition.

If Greece defaults, which is very much the writing on the wall, the worst-hit would be German banks and financial institutions. According to Reuters, the measure was part of a July 21 agreement by euro zone leaders meant to solve the crisis by providing a second bailout for debt-stricken Greece, partly funded by private sector bondholders, and providing more firepower to prevent contagion engulfing bigger EU economies Spain and Italy. But that deal failed to stop Italian and Spanish borrowing costs soaring, forcing the European Central Bank to intervene in August to buy their bonds, and may yet unravel in Greece, which has fallen behind again on its deficit reduction targets, pushing it closer to default.

According to The Washington Post, Europe is caught in a long bout of something that we’re very used to seeing after financial crises: extend and pretend. The underlying reality of their dilemma is that there are hundreds of billions — or maybe more — in losses for someone to take. If Greece and Ireland and Portugal take them, that means default and likely exit from the Euro. If they default, that means defaulting, in large part, on loans owed to German and French banks, which could cause a banking crisis in those countries. For them not to default, however, means that taxpayers in other European countries have to take those losses.

The solutions to this crisis that are economically plausible are not politically plausible. What is proving politically plausible is to do just enough to survive the week, and do it in the nick of time. The longer Europe spends under this cloud, the harder it is for them to grow. The harder it is for them to grow, the worse these debts become. And the worse these debts become, the harder they are to pay off. The cost of denying the problem is to make the problem worse. But for Europe’s leaders, that is, at least for now, an easier price to pay. Actually fixing the problem might ultimately be cheaper, but it requires a wealth of political capital and continental unity that they simply don’t have. One by one, European parliaments are blessing a $600 billion bailout fund considered an important step in solving the region’s financial crisis. But there is an unspoken problem: The fund may not be big enough to do a job that involves backing such major countries as Italy and Spain and boosting capital levels in the region’s financial system. Germany’s parliament delivered an important vote of approval Thursday for the European Financial Stability Facility. But even if other governments follow suit, officials will need to pivot quickly into a contentious debate about how to boost the size of the fund to perhaps several trillion dollars. That’s what many analysts feel is needed for the 17-nation euro zone to prove its commitment to standing behind weakened euro-zone governments and the region’s financial system.”

Three bold steps are needed. First, the governments of the eurozone must agree in principle on a new treaty creating a common Treasury for the eurozone. In the meantime, the main banks must be put under European Central Bank direction in return for a temporary guarantee and permanent recapitalization. The ECB would direct banks to maintain credit lines and outstanding loans, while closely monitoring risks taken for their own accounts. Third, the ECB would enable countries such as Italy and Spain to temporarily refinance themselves within limits at a very low cost. These steps would calm markets and give Europe time to develop a growth strategy, without which the debt problem cannot be solved.”

The European Union’s long-term problem is a structural flaw. It shares a common currency but not a system to ensure that its individual members are fiscally responsible. The United States faced a similar challenge in 1790, when Treasury Secretary Alexander Hamilton engineered the federal assumption of state debts incurred during the Revolution — a remarkable success, which caused the price of American bonds to soar. Only Germany has the strength and standing to play a similar role in Europe. But Germans are reluctant Hamiltonians. They naturally resist paying the bills for their profligate European cousins. And other nations have plenty of historical reasons to fear German dominance in Europe. Still, Germany is being led, step by shuffling step, into this role.”